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MUMBAI: The cash-strapped finance ministry has made it compulsory for banks to meet bad loan recovery target for fresh capital investment, a move that could improve the profitability of lenders and reduce bad loans in the future.

The government has mandated state-run banks to recover at least 20% of their written-off loans to receive any capital this fiscal, said two bankers familiar with the directive. This was conveyed to bankers recently, they said preferring anonymity.

"The government is giving thrust to recovering more than lending," said the head of recovery at a state-run bank who did not want to be identified. "The government had said that we must have a recovery target of 20%-30%. Capital investment will depend on the recovery."

Bad loans are a source of worry for the banking sector, with accounts such as Kingfisher Airlines and Deccan Chronicle defaulting. Besides, more than Rs 3.25 lakh crore in loans may be restructured, of which a fourth may turn bad if economic growth does not improve.

"Performance of PSU banks, compared to their private-sector peers, has highlighted the need to work towards recovery," said Saurabh Tripathi, Partner and Director, BCG. "Government's decision to link capital infusion to recovery is trying to incentivise banks to beef up recovery capabilities."

The total written-off assets of PSU banks was at Rs 2,300 crore in 2011-12, RBI data showed. At the same time, PSU banks recovered Rs 47,800 crore while the gross NPA was at Rs 1.17 lakh crore.

P Chidambaram on Thursday said the government in the next two weeks will finalise the investment plans for banks, but the total will be capped at the budgeted Rs 15,000 crore.

In a bid to improve recovery, many banks have added staff to their recovery cells.

Banks are taking steps to meet the set target by forming recovery cells. Also, to meet regulatory capital requirements, public sector banks need Rs 17,000 crore in this fiscal year. Recovery ratio- loans recovered during the year as the percentage of gross NPAs outstanding- improved to 59.8% in 2011-12 from 56.8% a year before.